Thursday, April 30, 2009

The New Paradigm

Soros, George. The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. New York: Public Affairs, 2008.

Reviewed by T. Hatch

George Soros writing in early 2008 (well before the bottom fell out of the world's financial markets) is quite blunt in his assessment. Unlike the previous economic crises of the past twenty five years or so the current economic woes represent the end of an era. The sea change that has occurred means that the half-century long expansion of credit with the U.S. as the dominant power, and the dollar as the main reserve currency of the world, is essentially over. Alas, the lust for leverage does come with a cost.

An interesting aspect of this book is that Soros makes an argument for being taken seriously as a philosopher. He seeks to explain the current state of economic affairs as well as providing a new way forward through his theory of reflexivity. He argues that market participants operate within a system where two functions simultaneously occur. The cognitive function is about seeking to understand the world while the participating or manipulative function is about a guide to action. Further, these separate functions of thinking and reality are often directly opposed to each other; sometimes they interfere with each other. This interference is “reflexivity.”

Buttressing Soros' concept of reflexivity is the notion of radical fallibility. The basic premise is that we are bound to be wrong. As a practical matter economic actors habitually operate on the basis of imperfect knowledge and their actions have unintended consequences. Unlike rational expectation theory (the basis of the old paradigm which Soros seeks to supplant) the new paradigm does not set out to create an artificial world in which equilibrium prevails. It is this belief in the market equilibrium orthodoxy that “is directly responsible for the current turmoil.” Regulators abandoned their responsibilities reckoning that the market would correct itself. This hubris was a direct result of those who held that equilibrium theory is a scientific theory. The days are clearly numbered for equilibrium theory and its “political derivative” market fundamentalism.

The irony of this largely persuasive argument is that Soros, an acolyte of the philosopher Karl Popper, is positing a fundamentally Hegelian system. It is this “dialectic” of thought versus action which propelled Soros to the top of the hedge fund universe. Another obvious irony is that Popper was stridently anti theory. It is problematic whether Soros' argument rises to the level of a philosophical system but nonetheless it does seem valid.